Profit margins are becoming a key controversial issue in the inflation discourse 🤬
Why are companies still charging high prices for stuff? 🤨
Has Corporate America been paying its fair share of the inflation that everyone’s experiencing?
“Fair” is a loaded term, and I’m not going to claim to have a good definition for it in this context.
But as more people become familiar with the way inflation has been passing through companies, there’s likely to be more people arguing that companies have not been picking up enough of the slack.
It’s an issue that was raised by U.S. Sen. Sherrod Brown on Tuesday during Fed Chair Jerome Powell’s semiannual appearance before Congress. Bloomberg’s Tracy Alloway and Joe Weisenthal have been all over it in their recent reporting.
Let’s get into it.
Why consumers might’ve been okay with paying up 🤷🏻♂️
Despite high inflation, record-high spending figures show consumers have been willing to pay up for goods and services.
But sentiment data continue to show consumers aren’t thrilled about how much more they’re spending these days.
With this being the case, why haven’t consumers pushed back more aggressively?
JPMorgan economist Michael Feroli offered an explanation. From the Sept. 19, 2022, TKer, “Are 'gravity-defying' profit margins finally coming to an end? 💸“:
Surveys by behavioral economists (including Daniel Kahneman and Richard Thaler) indicate that certain price increases antagonize customers more than others. Raising prices because demand increases is seen as unfair, whereas passing along wholesale prices increases is generally seen as fair.
One unusual aspect of the current spike in inflation is the visibility of the supply chain issues. Los Angeles residents have even been able to see the backlog of container ships from shore. This has likely made it easier for business to justify passing along higher prices.
Indeed, media outlets — including TKer — have written a lot about how pandemic-related supply chain issues and the war in Ukraine caused supply to lag demand, forcing costs to surge. Companies have also been very vocal about these challenges.
So the perception took hold that higher prices were unavoidable, as it would be unreasonable to ask businesses to operate at a loss.
Flush with savings and lower debt levels, consumers were more than able to pay for what they needed or wanted. And they continue to do so at a record rate.
But Corporate America has been very profitable 📊
As consumers have been spending an increasing share of their incomes while chipping away at their excess savings, you’d think businesses would similarly report that profits were significantly lagging sales as rising costs eroded profit margins.
But that didn’t really happen. In fact, for much of this period, companies reported expanding profit margins. For more on this, read: The biggest corporate red herring ❌
S&P 500 companies reported record profits in 2021 and 2022, and analysts expect new records in the years to come.
More recently, margins have begun to contract from record-high levels. And some industries have certainly been hit harder than others. But generally speaking, analysts nevertheless expect margins to trend at historically high levels.
Back in November, UBS economist Paul Donovan put a spotlight on this discrepancy in a widely read op-ed for the Financial Times.
“[C]onsumers seem to be buying stories that seem to justify price increases, but which really serve as cover for profit margin expansion,” he said.
Here’s the excerpt Sen. Brown shared on Tuesday:
…[the] Fed should make clear that raising profit margins are spurring inflation…Companies have passed higher costs on to consumers. But they have also taken advantage of circumstances to expand profit margins. The broadening of inflation beyond commodity prices is more profit margin expansion than wage cost pressures.
In an Odd Lots podcast released Thursday, Bloomberg’s Alloway called the phenomenon “excuseflation.”
From Alloway and Weisenthal’s writeup of the podcast:
…a growing body of analysts and researchers see this pattern playing out across Corporate America, with companies using unusual disruptions as an excuse to raise prices for their goods and services, thereby allowing them to expand profit margins.
And over the last few years, businesses have been able to point to a smorgasbord of “once-in-a-lifetime” emergencies stemming from the pandemic and Russia’s invasion of Ukraine, which together have effectively roiled everything from semiconductor production to commodities markets and shipping.
The key question is, in an economy where the consumer continues to spend freely, how sticky this ‘excuseflation’ proves to be…
Once companies enact higher prices, there isn’t a lot of motivation to reverse them.
The result is a surge in profit margins at both Pepsi and Coca-Cola — and across major companies in general.
It’s a point picked up by UMass Amherst economists (and frequent Odd Lots guest) Isabella Weber and Evan Wasner. They cite an explosion in corporate profit margins to a record 13.5% in the second quarter of 2021 as evidence that companies are going beyond simply passing on higher input costs to customers…
Alloway and Weisenthal go pretty deep into all this. I’m not going to repost all of it here. Head over to Bloomberg, and check out their podcast, transcript of the podcast, and writeup of the podcast.
Zooming out 🔭
As consumers, none of us want to pay high prices, especially if prices are rising faster than our incomes. So, it’s outrageous to learn that companies are keeping prices high even as their costs improve.
As investors, the situation is a bit more nuanced. Because profits are the most important driver of stock prices in the long run, higher profit margins are welcome news if they help the bottom line.
But as Alloway and Weisenthal articulate, “…while higher profit margins on the surface would seem to be a benefit for investors, when every company is in a position to raise prices, that’s the behavior that keeps prompting members of the Fed’s Federal Open Market Committee to ratchet up interest rates again and again, putting a lid on stock prices.”
In other words, this profiteering is self-defeating as the Fed-sponsored market beatings will continue until inflation improves.
So how does this story end?
The Fed thinks it ends with higher financing costs (via tighter monetary policy) destroying enough demand that those on the supply side of the equation ease up on prices. This risks pushing the economy into recession with unemployment rising significantly.
An alternate ending 🤔
There might be a better way out of this.
Here’s a controversial idea I buried in the Oct. 26 and Nov. 6 TKers:
…perhaps it’s time for customers to push back harder and call the bluffs of businesses that are selling them unnecessarily high-priced goods and services.
This sort of consumer rebellion may help bring inflation down sooner, which in turn should convince the Federal Reserve to ease up on its growth-destroying, market-unfriendly policies.
To put it more explicitly, consumers could push back by actively cutting back on spending.
I recognize this is the kind of thing that risks sending the economy into recession. But this end result of demand destruction is exactly how the Fed is trying to bring down inflation — the Fed is just aiming to destroy demand by putting people out of work and giving companies more leverage to not raise pay aggressively.
If consumers (it doesn’t have to be everybody) cut back on spending (a little can go a long way), then they can destroy demand on their own terms — and not the Fed’s. Rather than having the Fed forcefully taking away some people’s ability to spend, consumers who are able to could voluntarily cut back. (They could start by cutting back at companies that have been raising prices while publicly celebrating their resilient profit margins.)
I’m just spitballing. Got a better idea? Send me your thoughts: firstname.lastname@example.org.
Related from TKer:
I find it assuming how liberal politicians complain that corporations make too much money while also complaining that they don't pay enough tax. Ceteris paribus, wouldn't they pay more tax if they made more money?